Can a Bionic ARM Still Pay Off?

Richard Saintvilus |Contributor

Tuesday, 1 May 2012 | 11:46 AM ETThe Street

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It is broadly understood that chip stocks have become one of the best derivative plays on the market — and for good reason. The growing popularity of smartphones and mobile devices from Apple and Google have made household names out of once-obscure players such as TriQuint Semiconductor and Cirrus Logic, while also sending dominant names such as Qualcomm to new heights. The surprise performance of these chips shows how strong Apple’s famed “halo effect” really is.

One name that has become very prominent is ARM Holdings. Unlike rivals that also get rewarded from exposure to Apple devices, ARM has decided to play the role of the “sneaky diplomat” by also licensing its chip technology to the highly anticipated launch of Microsoft’s Windows 8.

The question is, for a stock that is already grossly expensive, how much more upside is there for ARM, regardless of how successful Microsoft’s launch might be? Or more appropriately, can a “Windows effect” produce more than an ARM’s-length of growth — at least to the extent it can justify a higher stock price?

As impressed as I am with ARM’s business model and the fact that it is able to forge deals with competing companies, its stock price suggests it is priced for perfection and for me this has always been a great source for concern, much less thinking Windows 8 can wring out some untapped value.

Its enormous price-to-earnings ratio of 55 implies that the company already has huge expectations to fulfill. I just don’t think that Windows 8 will be enough to help it grow into that multiple — at least not with any noticeable urgency. That said, I wouldn’t completely rule out the company’s investment worthiness — at least not without a look at its recent earnings results.

The Quarter That Was

For the period ending in March, the company reported revenue of $209.4 million — representing an annual increase of 13 percent — well ahead of analysts’ estimates of $201.2 million. The company also beat estimates on earnings per share of 16 cents.

For the quarter, gross margin arrived at 94 percent, 30 basis points better than the prior-year quarter. Operating margin was 37.9 percent, 12.9 percent better than the prior-year quarter, while net margin registered at 28.2 percent, or an improvement of 9.7 percent sequentially.

When analyzing the report, I took some good with some bad. For a stock that is priced for perfection as is ARM, any sign of weakness will draw a red flag. So I have no shame in admitting that I also scoured for “less than perfect” examples on its report.

One such discovery was the fact that although the company logged a 13 percent increase in revenue from the previous year, that was still 4 percent below the previous quarter. It’s far too early to suggest what that might mean, but I was also unimpressed by its paltry 6 percent growth in royalties.

Looking Ahead

In terms of outlook, the company didn’t offer very much, but did seem enthusiastic about its backlog and licensing pipeline — both of which were described as “robust.” On that note, it added that it sees group dollar revenue for the full year to be in line with what the market already expects — essentially, revenue of $879 million — representing an increase of almost $20 million over the full-year consensus estimate in place at the end of January. For the coming quarter, the company expects revenue of $211 million and earnings per share of 15 cents.

The Bottom Line

Overall, the numbers were good, but not great and certainly far from perfect — even though the market continues to price the company as if it is. As fruitful as its Microsoft partnership might prove to be on top of the relationship it already has with Apple, I still see some challenges ahead for the company, as competition within the space is only going to get more intense.

For that matter, consider Intel, a name that has posed as a sleeping giant for quite some time and now the company appears poised for a resurgence to add more obstacles in front of ARM’s ability to grow into its inflated valuation. From an investment perspective, as good as its business appears to be, its stock price suggests that I stay away.